The Role of International Capital Markets in Microfinance

By Brad Swanson, Partner, Developing World Markets (www.dwmarkets.com)

Tel: 703 938 0198, Email: brad@dwmarkets.com

Introduction
In the past three years, international capital markets have awoken to the attractiveness of
investing in microfinance. Approximately $500 million has been raised in one-off
transactions –collateralized debt obligations, private placements and direct securitizations
of microloans. In addition, private sector debt and equity microfinance funds have sprung
up -- for investors who prefer to give discretion to professional managers-- and are now
thought to control more than $2 billion.

While traditional microfinance funders -- non-profit organizations, governmental

development agencies and individuals -- are behind much of this surge of investment, the
big change since 2004 is the introduction of private sector institutional investors seeking
full market returns. These mainstream commercial investors, most located in Western
Europe and the USA, are driving the opening of capital markets to microfinance.

How and why commercial mainstream investors have come into microfinance and the
likely evolution of capital markets funding for microfinance is the topic of this paper.
(Note that by “capital markets” we mean transactions or funds in which all or a major
portion of the investment is raised from private sector institutional investors seeking fully
risk-adjusted returns.)

The Need for Capital Markets Funding in Microfinance

When properly conducted, microfinance is a profitable, low risk and expanding financial
activity. For example, the 26 widely dispersed microfinance institutions (MFIs) in
Microfinance Securities XXEB, a $60 million collateralized debt obligation sponsored by
Developing World Markets in 2006, have an average return on equity of more than 20%,
a portfolio at risk (payment delays beyond 30 days) of only 2.5%, and are growing their
loan portfolios by more than 30% per annum.

Already, the number of borrowers served by MFIs is estimated at 100 million. With an
average loan size of $170, the total market size is estimated at $17 billion. Yet the
potential demand is 15 times the current market -- estimated at 1.5 billion, or half the 3
billion global working poor. Thus microfinance represents a total commercial market of
more than $250 billion. (Market size data in this paragraph and the next two comes from
“Optimising Capital Supply in Support of Microfinance Industry Growth”, a presentation
by McKinsey & Company to the Microfinance Investor Roundtable in Washington DC
on 24 October 2006).

Currently more than ¾ of the $17 billion funding total is raised from domestic markets.
However, this number is skewed by the amount – almost $6 billion – coming from
deposits in the few countries where MFIs are allowed to take deposits. Most of the
estimated 10,000 existing MFIs are not deposit-taking institutions, and are unlikely to
become so, given the cost and complexity of complying with regulations typically

The Role of International Capital Markets in Microfinance – Brad Swanson 1

applied to institutions taking deposits from the public. Future funding for MFIs is thus
unlikely to be sourced mainly from deposits. Domestic emerging country commercial
banks, which should be major funding sources for MFIs, are typically averse to lending to
them (see “Local Currency”). Moreover, capital markets in most developing countries are
thin and the major institutional players are averse to or legally constrained from
significant investment in microfinance. For these reasons, it is unlikely that domestic
sources in emerging countries will generate more than a fraction of the more than $200
billion that will need to be raised to satisfy potential demand.

Moreover, while non-commercial investors account for 80% of the $4 billion in funding
now coming from international sources, this is a legacy of the origin of microfinance in
charitable and officially sponsored development activity. As MFIs’ appetite for capital
grows exponentially, it is unlikely that government agencies and non-profit organizations
will increase their flow of funding proportionately: first, they will be faced with
competing demands for assistance; and, second, they will begin to question whether their
mission is best served by funding financial enterprises that are profitable and are
increasingly transforming into privately owned companies able to attract commercial
investment. (However, this realization may not have begun to sink in yet -- see discussion
of “role reversal” below in “The Contribution of Non-Commercial Investors”.)

The only available source of funding for commercial lending of this magnitude is the
international capital markets. Already, microfinance investment vehicles, which typically
include private sector institutional investors, are growing their investment portfolios at
233% per year, more than twice the rate of growth of microfinance investment from
official development agencies (according to a survey by a consortium of development
agencies called Consultative Group to Assist the Poor—CGAP). For the international
capital markets, funding a $200 billion industry is routine.

From Fund to CDO

The first microfinance fund to reach beyond socially responsible investors was
established in 1998. The Dexia Microcredit Fund, sponsored by Dexia, a Franco-Belgian
bank, and advised by BlueOrchard Finance SA, based in Geneva, offered investors a
return above their cost of funds (typically 1-2% over LIBOR) and an ability to redeem
their investments. By 2004, assets under management had grown to $45 million. (The
Dexia fund has about $170 million under management currently.)

As a fund (a Luxembourg-based SICAV) offering redemption rights to investors, Dexia

needs to keep its maturities to MFIs relatively short and a large portion of its assets in
cash (at least 20%). This limits returns to investors and attractiveness of Dexia’s funding
to MFIs, many of which need longer-term maturities on a portion of their liabilities to
better manage risk.

In order to provide longer-term funding to MFIs and more attractive rates to investors,
BlueOrchard partnered with Developing World Markets (DWM), an emerging markets
fund manager and advisor based in Connecticut, in 2004. Together they created the first
collateralized debt obligation (CDO) based on microfinance risk and sold in the

The Role of International Capital Markets in Microfinance – Brad Swanson 2

international capital markets: BlueOrchard Microfinance Securities I (BOMSI). The first
closing of $40 million occurred in July 2004 and a subsequent closing of $47 million was
held in April 2005. In both offerings, investors purchased seven-year notes with a single
repayment of principal at maturity, the proceeds of which were used to fund loans of the
same maturity to the MFIs.

This transaction looked very different from any existing microfinance investment vehicle
and it marked the beginning of mainstream capital markets investment in microfinance.

To begin with, BOMSI is not a fund – investment decisions are not handed off to a
professional manager. There is no asset substitution or active management. Investors in
BOMSI have a single source of repayment, a static pool of 14 loans to MFIs taken on at
closing. When investors came into BOMSI, they did so on the basis of their own
assessment of the credit risk of the underlying MFIs – and they have to live with this
decision for seven years.

Legally, BOMSI is a special-purpose vehicle (SPV)– a limited liability corporation –

registered in the business-friendly state of Delaware. The vehicle is limited by its
constitutional documents solely to servicing its loans to MFIs and repaying its creditors.
Cashflows from debtors to creditors pass transparently through the vehicle. When the
loans pay off and the liabilities mature, BOMSI will make its final payments to investors
and be liquidated.

Secondly, BOMSI’s funding is stratified in five levels of risk – senior, three classes of
subordinated, and, at the bottom, equity. (Both BlueOrchard and DWM are equity
investors in BOMSI.) The cashflow from BOMSI’s loans to MFIs is applied according to
a strict order of precedence, known in structured finance as the “cash waterfall”. Senior
investors are paid completely first, then the other classes in order of precedence. Equity
investors do not get a current return on their investment but if, after all MFI loans have
reached maturity and all other investors have been repaid, there is residual cash left in the
BOMSI SPV it will be allocated to the equity investors.

Third, BOMSI’s investors do not hold units in a fund and have not made loans to
BOMSI. Rather, they have purchased securities – bonds and equity interests. As we will
see later, this distinction was important in attracting institutional investment.

These elements are common to CDOs and other forms of securitization in more-
developed asset classes such as mortgages, corporate loans, auto loans or student loans.
But these are asset classes with substantial data going back a number of years describing
default performance under a number of economic scenarios. In the microfinance industry,
by contrast, MFI write-off policies vary widely and data on microloan defaults typically
are not recorded consistently by different MFIs. Moreover, these data typically are
neither independently audited nor rigorously modeled to determine likely performance
under varying circumstances. (Although recently, a non-profit research firm, Center for
the Development of Social Finance, did a static pool analysis of more than 600,000
microloans from two MFIs – SKS in India and IMON in Tajikistan – using developed

The Role of International Capital Markets in Microfinance – Brad Swanson 3

world methodology, in order to demonstrate that at least some MFIs are rigorous enough
in their record keeping to permit this style of analysis.)

Moreover, BOMSI securitized loans to only 14 institutions in nine countries – much less
diversification than typical CDOs or other securitization transactions in developed
markets, where the asset pool may comprise many hundreds or thousands of loans.

Given these factors, implementing a CDO for the microfinance industry required
changing the way investors viewed both microfinance and the CDO product.

Introducing Commercial Investors to the Microfinance CDO

Despite the relative paucity of data and diversification, DWM, which took primary
responsibility for structuring the transaction, encouraged investors to compare BOMSI to
mainstream commercial investments. DWM held the view that to attract sufficient
investor interest, BOMSI had to reach beyond the circle of funders primarily motivated
by social, not financial, returns.

To distinguish BOMSI as a commercial investment – different from investment funds,

donations to NGOs or other means then available to support microfinance -- DWM
highlighted the following:

Low default rate in MFI loan portfolios. All participating MFIs reported default
rates below 1%. Although reporting systems were not consistent or their results
independently verified, the professionalism and the track record of the MFIs
themselves added credibility to their findings.

Favorable risk-return ratios. The tiered capital structure enabled BOMSI to offer
high returns to the higher-risk tranche investors, while providing the lower-risk
investors with a substantial degree of collateralization, enabling them to feel
satisfied with a low credit spread over the benchmark Treasury bond because their
notes had the highest priority of repayment. Investors were not asked to discount
their return expectations in view of the presumed social value of microfinance.
With a variety of securities offering different risk and return parameters, DWM
was able to segment the international investor base and thus appeal to a wide
spectrum of potential investors.

Familiar investment instruments. BOMSI debt investors purchased bonds drafted

in language, and carrying features, common to commercial bonds. They benefited
from the appointment of a trustee to safeguard their interests, as is the case in
most bond issues. While the bonds are not listed, and there have been no
secondary trades to date, each series has a unique CUSIP number which facilitates
recordkeeping, valuation and permitted transfers. These features helped to ensure
that investors had a high comfort level with the form of the investment and could
focus clearly on the underlying risk and return.

The Role of International Capital Markets in Microfinance – Brad Swanson 4

In one important respect BOMSI was differently structured from other commercial
transactions: OPIC, the United States government development agency, purchased the
most senior tranche of securities. Note that OPIC’s ownership of the senior tranche
conveyed no protection to more junior investors – by virtue of the cash waterfall, they
were exposed to risk in the MFI loan portfolio ahead of OPIC. However, the participation
by a large and well-respected development agency – often referred to as “the halo effect”
-- encouraged investors who otherwise might have been unwilling to consider the
transaction.

Growing Participation by Commercial Investors

In the event, the first closing of BOMSI attracted only $1.5 million, or 4% of the capital
raised, from private sector investors seeking a full market return (see table below).
However, by the time of the second closing, nine months later in April 2006, interest in
the transaction had spread and commercially-motivated institutional investors accounted
for 41% of the amount invested. Moreover, the commercial investment came from a
wider spread of investor types.

A little over a year later, in June 2006, DWM closed its third CDO transaction,
Microfinance Securities XXEB (MFS), for which it was sole sponsor. This $60 million
securitization of loans to 26 MFIs had more investment primarily commercially-
motivated than primarily socially-motivated. Moreover, for the first time commercial
investors (besides the sponsor) purchased equity. By this time, not only had market
familiarity with microfinance grown, but DWM had also obtained an investment grade
rating –A -- on the MFS senior notes from MicroRate, a specialized microfinance rating
agency. This heightened commercial investors’ comfort with the senior tranche. In
addition, DWM had sponsored a study indicating that microfinance is less correlated to
economic downturn than other emerging markets assets, making portfolios including
microfinance, in theory, less volatile. (See below, “On the Path to an Asset Class”.) This
development was of interest to commercially-motivated investors.

The table below shows the amount of investment in three CDO transactions contributed
by institutional investors seeking full market returns, with socially positive impact a
desirable additional benefit. The remainder of the investment came from investors whose
primary motivation was social – thus, for these, financial return was of secondary
importance.

The Role of International Capital Markets in Microfinance – Brad Swanson 5

 Commercially Motivated CDO Investors by Type and Risk Category

BOMS 1 BOMS 2 MFS Total

Investor Type USD USD USD USD
Bank 500,000 9,139,640 9,639,640
Money Manager 1,000,000 500,000 3,036,000 4,536,000
Insurance Company 500,000 1,000,000 1,500,000
Pension Fund 18,000,000 20,500,000 38,500,000
University Endowment 100,000 100,000
Total 1,500,000 19,100,000 33,675,640 54,275,640
% of Total Investment 4% 41% 56% 37%

BOMS 1 BOMS 2 MFS Total

Risk Category USD USD USD USD
Equity 1,500,000 1,500,000
Junior (1) 500,000 600,000 125,320 1,225,320
Mezzanine (2) 1,000,000 18,500,000 1,125,320 20,625,320
Senior 30,925,000 30,925,000
Total 1,500,000 19,100,000 33,675,640 54,275,640

Notes
(1) For BOMS 1and 2, Subordinated Notes C and B
(2) For BOMS 1 and 2, Subordinated Notes A
Source: DWM

High net worth individuals (HNWIs) constituted 10% of the investment amount in the
first BOMSI close. (They are not shown in the table above as we do not characterize
them as commercial investors.) This percentage fell in the second close and by the
closing of MFS, HNWIs as a group were down to under 5% of the total capital invested.

While there is doubtless a significant potential market among HNWIs, and among retail
investors generally, for microfinance risk, financial institutions are the bellwethers as
they have greater sophistication, more resources and stronger tolerance for volatility and
illiquidity.

In order to complete the picture on microfinance CDOs, we note that BlueOrchard

sponsored another CDO, with Morgan Stanley as placement agent, in April 2006, raising
$99 million. The entrance of Morgan Stanley, a “bulge bracket” investment bank, is
another signal that microfinance funding is gaining credibility as a capital markets
activity.

The Role of International Capital Markets in Microfinance – Brad Swanson 6

CDOs vs. Funds
CDOs were the first non-fund capital markets products in microfinance for several
reasons:
MFIs typically have balance sheets that are too small to justify transactions of the
scale required to access international capital markets-- aggregating MFI loans is
necessary
On the other hand, MFIs are used to borrowing internationally -- creating loans to
international standards and packaging them into the asset side of a special
purpose financing vehicle does not present insuperable challenges
Capital markets investors predominantly demand instruments denominated in
USD or euro. Although MFIs typically (but not always) lend in local currency,
they are used to borrowing in hard currency and passing the risk onto their
clients, whose demand for loans is relatively interest rate inelastic.
Top quality MFIs are found throughout the emerging markets so geographic
diversification can be achieved
MFIs typically have very few loan products, so their risk on the asset side is
relatively easy to analyze and can serve as a proxy for the underlying risk of the
microborrower – highly diversified, highly granular – that strongly draws the
typical capital markets investor.

While CDOs have become the largest feature on the microfinance capital markets
landscape, the relative scarcity of top-quality MFIs may slow the growth in this asset
category. Of an estimated 10,000 MFIs worldwide, fewer than 100 have qualified for
inclusion in a CDO to date. As market demand for CDOs grows, CDO arrangers will
need to push farther “down the pyramid” to tap MFIs of lesser size and credit quality to
generate assets. However, given the absence of data in the microfinance industry, as
noted above, the analysis of risk in CDOs is not a function of statistics but rather of
individual assessment of MFIs.

Investors find it difficult to make the time necessary to take individual credit decisions on
numerous MFIs, especially given that the investment represents only a very small part of
the investor’s portfolio responsibility. Up to now, the presence in CDOs of MFIs that are
mostly top-ranked – demonstrated either through ratings or performance over time – has
served to ease these credit decisions. But with the top tier of MFIs growing “overbanked”
(see below, “Is Microfinance Riding for a Fall?”), CDO arrangers will need to persuade
investors to take risks on MFIs that are less known or appear financially weaker. Part of
this persuasion may come through education – some smaller MFIs may be as credit
worthy as their larger peers – but structural features such as credit guarantees or higher
collateralization levels may become necessary in some deals to assuage investor concern.

While the CDO has been gaining favor as an investment instrument, investment funds
have also been growing, and are thought today to control more than $2 billion of capital,
according to a CGAP survey. Of course, investment funds in microfinance are not new.

The Role of International Capital Markets in Microfinance – Brad Swanson 7

Traditionally, low-return or no-return funds sponsored by non-profit organizations have
been a major source of funding for microfinance.

What is new is an emphasis on funds that actually offer a return to investors. Even today,
however, of the 79 microfinance funds listed by MicroCapital, a microfinance news and
research service, only 19 actually disclose that they offer a return to investors (see
http://www.microcapital.org/cblog/). And of those that offer a return, most have targeted
returns that are below the typical cost of funds to the investor.

Would-be institutional microfinance fund managers have several hurdles to overcome in

persuading clients to invest:
Investment fee “cascades”: Institutions that manage funds make it a practice
for their funds not to invest in other funds in order to avoid a buildup of fees
that erodes the ultimate returns to their investors. Also, ceding investment
discretion to others may appear to weaken their own standing as managers
Lack of transparency: Investors may find it difficult to understand the pricing,
volatility and performance of assets that exist primarily in funds, as the
portfolio effects and the manager’s screening activities could mask the
underlying data
Liquidity: Funds typically trade off liquidity (ie redemption) for return. If they
provide an easy exit for investors, funds that invest in illiquid assets like
microfinance will find it necessary to keep a relatively large percentage of
their portfolio in low-yielding cash. Investors with long time horizons, as
many institutions have, may prefer to invest directly in the underlying assets
and run the liquidity risk.

However, funds do play an important role in the growth of capital markets access for
microfinance. For example, many institutions will choose a fund as their first investment
in a new asset category, relying on the manager’s experience and knowledge of the
market to enhance the investor’s comfort level, as well as to gain familiarity with a
multiplicity of MFIs through a single investment.

Microloan Securitizations
CDOs and funds that specialize in senior loans to MFIs are the two largest elements in
capital markets investing in microfinance, but direct securitization of microloans has
attracted a great deal of interest, as microloans are relatively homogenous and vastly
diversified. As the spectacular growth of mortgage-backed securities in the US markets
makes clear, investors welcome a “pure play” risk on granular financial assets. However,
several important constraints are slowing the emergence of a true asset-backed notes
product in microfinance:

Short maturity of microloans: As opposed to 30-year mortgages, most microloans

mature in less than a year and feature frequent amortization, so that all but the
shortest-term microloan securitizations will need to incorporate a mechanism to

The Role of International Capital Markets in Microfinance – Brad Swanson 8

 roll over or substitute the underlying assets, which greatly increases the
structuring complexity and administrative cost.
Origination risk. Because the portfolio of underlying microloans needs constant
replenishment, the ability of the MFIs continually to originate a sufficient volume
of microloans is a significant additional risk.
Important role of servicer: Successful MFIs cultivate intimate relationships with
borrowers. Thus the MFI role in servicing securitized microloans is a critical
element in the performance of the securitized portfolio. This makes it difficult to
portray microloan securitizations as pure borrower risk. In effect the performance
risk of the MFI servicer is a key component in the overall risk profile – and a
difficult one to quantify, much less hedge against.
Government regulation: Many emerging market jurisdictions have non-existent,
rudimentary or inflexible regulatory structures that pose daunting obstacles to the
legal structuring necessary to set up securitization vehicles, execute true sales of
microloans, and transfer payments transparently to offshore investors.

Given these constraints, there have been only two case of microloan securitization in
international capital markets (as opposed to CDOs that securitize loans to MFIs), and
both of them have featured substantial credit enhancement by non-commercial investors.

In May 2006, ProCredit Bank Bulgaria, a subsidiary of ProCredit Holding AG,

sold €48 million of its loan portfolio to institutional investors in a deal rated BBB
by Fitch Ratings. The European Investment Bank and KfW, the German
development agency, provided partial guarantees.
Four months later, BRAC, a large Bangladesh MFI, held the first close of a
program, backed by microloans, which will issue $15 million (local currency
equivalent) of 6-month maturity notes twice a year for 6 years. The issue was
rated AAA by a local rating agency. The partial guarantors were KfW and the
Dutch development agency FMO.

Equity
As MFIs mature and transform from non-profit organizations into companies, including
in some cases regulated institutions, their need for equity grows. With the high ROEs and
fast growth of the industry, the IRR of MFI equity investment looks compelling on paper.
Yet there have been only a handful of private equity funds set up to address this need.

The major factor slowing the growth of commercial equity investment in MFIs is the
small number of exits to date. Most private equity investors look more to capital gains
upon sale of their stakes and less to dividends as the principal component of their return.
This is appropriate in microfinance as MFIs need to retain earnings in the business to
finance further growth if they are to escape an endless cycle of sourcing fresh equity. But
without a deep track record of successful exits, the private equity investor is entitled to
puzzlement if not skepticism regarding the prospective return on MFI equity investment.

The Role of International Capital Markets in Microfinance – Brad Swanson 9

The only private equity fund that has gone through a complete cycle of investment and
liquidation is ProFund Internacional SA, which from 1995-2005 invested approximately
$20 million total in 10 Latin American MFIs for an annual average return of 6%.
ProFund is of interest here not for its financial returns – it was sponsored by socially
motivated investors and did not set out to maximize profits – but for its success in
realizing all 10 exits within its allotted 10-year life.

All but one of ProFund’s exits came from sales to shareholders or sponsors of portfolio
MFIs, several of them pursuant to puts or various forms of shareholder agreements.
While effective in the case of ProFund, exits to insiders (management, major
shareholders and sponsors) are worrisome to private equity investors if they are the only
feasible means of liquidating investments. Investors prefer a mix of mechanisms
including those that bring in third party buyers, such as initial public offerings, mergers
and acquisitions, in order to set arm’s-length pricing and foster competition. Moreover,
puts to insiders expose the put-holders (ie, investors) to the credit risk of put-writers (ie,
insiders), and expose the put-writers to substantial future liabilities they may not be
willing to take on, or may accept only at very conservative valuations. If a put can be
agreed, and the credit risk of the counterparty is acceptable, the risk-adjusted return is not
likely to excite the private equity investor.

Acquisitions by financial or strategic investors are more welcome pathways to exit, but
there have been very few examples of this in microfinance. Microfinance networks might
seem to be likely acquirors but most, whether for-profit or non-profit, prefer to build their
own operations in new countries from the ground up or to partner with smaller, non-
corporatized MFIs. No substantial organization has attempted a “roll-up,” or a growth
strategy though acquisition to date.

Nor have there been more than a handful of microfinance IPOs, and few of those in local
markets with enough liquidity to provide assurance of full valuation.

It is likely that MFI acquisitions will make their appearance and grow rapidly in the
coming years. The fundamentals of microlending are roughly similar in most countries,
as shown by the success of networks that apply a common methodology across the
developing world. Strategic investors such as commercial banks, leasing companies and
insurance companies will see the value in MFIs not just as lenders but as delivery
vehicles for other financial services to a proprietary and loyal customer base. Already
some Western European banks have purchased Eastern European banks that specialize in
small and micro enterprise lending in order to extend their footprint into the European
Union hinterland. In addition, a Venezuelan bank recently purchased a large block of
shares in a major Bolivian MFI, although political considerations may have counted as
much as financial ones in the decision.

Another likely source of acquisition is by a competitor. Already some countries,

including Bolivia, Ecuador, India, Nicaragua and Peru, are seeing competition among
MFIs that previously relied for growth on an underpenetrated market.

The Role of International Capital Markets in Microfinance – Brad Swanson 10

The Contribution of Non-Commercial Investors
As we saw in the BOMSI case, an official development agency can provide credibility
and ease market acceptance of a product even without direct enhancement of risk. But as
international capital markets grow more familiar with microfinance, the value of the
“halo effect” is diminishing. Yet non-commercial investors are not superfluous in
microfinance. They can play a valuable role in taking on risks that commercial investors
don’t understand or are uncomfortable with, and in so doing leverage this investment.

For example, the Global Commercial Microfinance Consortium, sponsored and managed
by Deutsche Bank, is a $75 million facility whose investors include socially responsible
HNWIs, official development agencies (from the US, the UK and France), foundations,
and also a number of commercially motivated investors such as banks, insurance
companies and pension funds. The facility will make it easier for MFIs to obtain local
currency loans from local banks. While we deal with local currency issues later in this
paper, the importance of the facility for this section is to recognize that most institutional
investors are uncomfortable taking local currency risk, especially inasmuch as many
currencies in emerging markets either cannot be hedged or can only be hedged at
unacceptable cost.

In essence, the GCMF takes advantage of the ability of non-commercial investors to

shield commercial investors from risks they are unwilling to take on, thus leveraging the
risk capital of the non-commercial investors to the benefit of both.

As we saw above, the role of non-commercial investors in funds such as GCMF and in
CDOs such as BOMSI is salutary. Whether providing a halo to comfort commercial
investors or actually taking on risk that commercial investors feel uncomfortable with,
non-commercial investors can significantly speed up access to capital markets investment
for MFIs. But it appears that bilateral and multilateral development agencies are going
beyond this role and actually crowding out private sector investors in commercially
credible deals.

MicroRate, a Washington DC-based MFI rating agency, has published a study recently –
Role Reversal: Are Public Development Institutions Crowding Out Private Investment in
Microfinance?, February 2007 – showing that “development agencies are today heavily
concentrating their funding on the largest and most successful MFIs, exactly the target
investment market of private investors”. The study claims that development agencies tend
to make easy choices and with their subsidized finance rates are squeezing private
investors out of the market.

In 2005 (last full year of data), the study found that the development agencies increased
their direct funding to top-rated MFIs by 88%. At the bottom of the pyramid, where
MFIs are most in need of the “patient capital” and technical assistance that these agencies
provide at taxpayer expense, the development agencies actually cut their funding to the
lowest-rated MFIs by 25%.

The Role of International Capital Markets in Microfinance – Brad Swanson 11

Shortly after the appearance of the publication, a number of private sector microfinance
funders joined together to appeal to the development agencies to change this practice, but
as of this writing the results are inconclusive. Clearly, if development agencies see their
roles as competing with private sector investors, they will slow the access of
microfinance to capital markets.

Local Currency
One of the largest constraints to growth of microfinance funding is the illiquidity and
volatility of many local currencies in the developing world. Of course, if MFIs were able
to rely on local funding sources, this would not be a problem. But, as we noted earlier,
the bond markets of most developing countries are thin and poorly regulated. Moreover,
institutional investors, the largest capital sources in these countries, are often highly
restricted in their permitted range of investments.

Paradoxically, local commercial banks, which should be a major source of funding for
MFIs, in many countries are less likely to accept MFI risk than foreign banks. This is
symptomatic of the larger problem of risk-aversion among these banks. In many
countries capital-hungry governments crowd out private lender borrowers. In some
countries, banks are content to lend to large corporations, parastatals, and foreign
businesses and are under no pressure to expand their presence into smaller indigenous
businesses. In some countries, banks have simply not made the effort to understand and
analyze MFI risk, assuming that “banking the unbankable”, whether directly or indirectly
through MFIs, cannot be prudent.

Foreign investors typically are uncomfortable with local currency risk that cannot be
hedged. This means that many MFIs must borrow in dollars or euros and push the risk
onto their borrowers. Fortunately for the MFIs the short maturities of their loans gives
them flexibility to effectively reprice their assets to account for currency fluctuations.
Even more fortunately for the MFIs, most borrowers are unable to access capital from
other sources and so accept interest rate hikes that a more affluent and competitive
market would challenge. Nevertheless, adjusting constantly to unforeseeable shifts in
exchange rates is a strain on MFI operations and imposes additional risk on borrowers.

On occasion, MFIs and offshore lenders hedge by depositing the hard currency loan in a
local commercial bank which then lends to the MFI in local currency, secured by the
deposit. (In a variant of this technique, the deposit-taking bank is different from the local
bank but issues the local bank a standby letter of credit to secure the risk of the MFI local
currency loan.) Although the local bank’s loan to the MFI is effectively risk-free, the
local bank frequently will not reduce the interest rate to the MFI by a large enough
quantum so that the combination of the local currency interest rate plus the guarantee fee
paid to the offshore lender for taking the risk works out as a feasible financing cost for
the MFI.

A number of initiatives are underway to provide unorthodox hedging facilities for capital
markets investors in thinly traded currencies. The Dutch development agency FMO, for
example, is putting together a swap vehicle capitalized with $350 million in equity that

The Role of International Capital Markets in Microfinance – Brad Swanson 12

would support $1.5 billion outstanding in currency swaps that are beyond the maturity
available commercially. By acting as swap counterparty for a basket of emerging market
currencies, the facility aims to achieve risk mitigation through diversification while
providing a substantial return to equity investors.

Ultimately, local currency markets will mature and provide efficient and flexible hedging
tools. In addition, by that time, local capital markets may have sufficiently matured to
lessen the strain put on foreign investment to meet MFIs’ growing capital needs.

On the Path to an Asset Class

The term “asset class” has a number of definitions. From an institutional investor’s
standpoint, an asset class is a kind of asset that is suitable for inclusion in an investment
portfolio. In order to be suitable, the asset class must fulfill certain requirements.
Fundamentally, it must be recognizable as a distinct kind of asset, such that different
investments in the same asset class can be analyzed together, can substitute for each
other, and can be relied upon to perform similarly in similar circumstances.

Crucially, the asset must be liquid, so that portfolio managers can trade into and out of
the asset easily according to their changing viewpoint and their portfolio’s cashflow.
Liquidity is a function of several factors including volume, exchange listings, ratings,
research, etc.

Additionally, it is important that the asset have a track record, data that can be analyzed
to make predictions about price changes in response to market conditions. If the asset is
relatively less correlated to other assets in the portfolio, that is, of course, a positive as the
overall volatility of the portfolio will be reduced by including the new asset in the mix.

Overall, microfinance funding is a long way from meeting these requirements. It

approaches the definition most closely in its distinctiveness and relative homogeneity.
But it is extremely illiquid and likely to remain so for an extended period of time while
volumes build up. Secondary markets are not likely to develop until there is a critical
mass of exposure among a large number of investors so that willing buyers can be
matched with willing sellers.

Interestingly, a case can be made that microfinance is largely uncorrelated to other

emerging market assets and so would reduce portfolio volatility, or beta. In a study
sponsored by DWM and carried out by New York University graduate student Nicolas
Krauss under the direction of NYU Stern School of Business Professor Ingo Walter, the
operating performance under different economic scenarios of 283 MFIs in 65 developing
countries was compared to that of 112 commercial banks from 33 developing countries.
The findings were that MFI financial results are less sensitive to economic downturn than
that of emerging market commercial banks. While the authors concede that the study is
based on somewhat inconsistent and incomplete data, it nevertheless serves as a useful
indicator and will likely lead to further useful investigation of the characteristics of
microfinance as a prospective asset class. (“Can Microfinance Reduce Portfolio

The Role of International Capital Markets in Microfinance – Brad Swanson 13

Volatility”, available on Social Science Research Network,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=943786.)

Is Microfinance Riding for a Fall?

Looking ahead, some microfinance investors see events on the horizon that worry them:

How will microfinance perform when the current economic expansion ends? The concern
is that the risk of default in the event of global or even localized recession is unknowable,
and may be substantial, for MFIs that have only operated during periods of prosperity.

This fear overlooks the fact that microfinance as a financial service segment is not
nascent, even though capital markets only recently “discovered” the asset. Many MFIs
have been in business for 10-20 years and have weathered significant economic and
political instability. Experience and research, such as the correlation study noted earlier,
indicate that MFIs are inherently less vulnerable to economic shocks than other finance
providers. (Of course, a sovereign event such as rescheduling or capital controls, or a
breakdown of law and order, could force default on even the strongest and most liquid
MFI, as well as any other debtor to external markets.)

The top tier of MFIs shortly may be “overbanked”. The fear is that too much investment
is chasing too little opportunity and that returns are falling to the extent that investors will
lend imprudently to lower quality MFIs in order to meet return expectations. The current
compression of emerging market spreads relative to higher rated paper, while cyclical,
highlights this concern.

However, while many of the best-known and largest MFIs are attractive candidates for
investment, many smaller and more obscure MFIs also have high quality credit risk. This
stems from the underlying robustness of the microfinance business model.

Most microenterprises operate “under the radar” of the formal economy. The level of
economic activity they engage in is so basic as to be immune from the normal ebb and
flow of the economic and political systems they operate in. Their operating margins are
commonly quite high (although of course small in absolute terms). Their employees are
family members or close associates whose terms of employment are informal and
flexible. Their owners’ liability for business debts is not limited by a legal form –
microborrowers take personal responsibility for the loans made to them, and they know
their ability to continue to make a living, and often to maintain the respect of their
community, is intrinsically tied to their punctual payment of all amounts due.

For the MFI, administering the loan book is time-consuming and labor-intensive, but
once the procedures are carefully designed, inculcated and tested in practice, operations
are usually stable, and extending the customer base of the MFI by opening new branches
becomes almost routine. Financial controls need to be strict and minutely observed,
however.

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In fact, it is difficult to find instances of default by MFIs that seek self-sufficiency (ie do
not view themselves as charitable operations) and have been in business several years.
Certainly some MFIs may have sought support from the international networks they
belong to in order to shore up a weakened balance sheet or improve faulty operations. In
addition, some MFIs are believed to understate their portfolio at risk numbers by
routinely extending the maturity of overdue loans. But MFIs that practice this usually do
end up collecting close to 100% of the principal and interest from the overdue borrowers.

Are MFIs abandoning their core constituency? A third concern is the move of some
MFIs upmarket along with their more successful clients. While the vast bulk of MFI
activity currently consists of small loans to individual micro-entrepreneurs (the common
meaning of “microfinance”, also called “microcredit” to distinguish it from other
financial services to micro enterprises) some MFIs have begun to offer more
sophisticated services to larger clients involving more substantial risks --small business
lending, mortgages, factoring, leasing, insurance, etc. This is a controversial
development. Some observers denounce MFI “mission creep” and worry that MFIs will
abandon their low-income clients as they progress upstream. Others believe MFIs can
continue to remain committed to poverty alleviation and still retain their more successful
clients as they accumulate wealth.

As these products take on more importance on MFIs’ balance sheets, the analysis of the
MFIs’ financial strength will grow more complicated, and their performance vis a vis
other emerging markets assets may grow more highly correlated, reducing their value in
lowering portfolio beta. On the other hand, as these MFIs grow to more resemble
mainstream financial institutions, both in terms of size and structure, they may attract the
attention of some mainstream analysts, traders and investors, further enhancing
investment sources and liquidity. Ultimately, while some MFIs may turn their backs on
their origins, most will keep their focus on microloans even while providing higher level
services, both because microfinance is good business in itself and because it will provide
the breeding ground for the higher value customers.

Conclusion
The rush of capital markets investment in microfinance is unprecedented and it is wise to
question its sustainability. Certainly, risks to continued growth abound, and we have
noted a number of them, including:

eventual exhaustion of investment opportunities at the well-known and accessible

tip of the MFI pyramid
structural obstacles to providing investors with direct exposure to microloans via
securitization
scarce track record of equity exits
lack of clarity regarding the role of non-commercial investors

The Role of International Capital Markets in Microfinance – Brad Swanson 15

 underdeveloped local capital markets, coupled with insufficient hedging tools for
foreign currency investment
illiquidity, sparse data and small volumes slowing the journey toward
achievement of “asset class” status
“mission creep” eroding MFIs’ distinctive risks and returns, and lessening their
value in reducing portfolio volatility

Many of these risks reflect the fact that microfinance has only recently been introduced
to capital markets. They should ease over time as investors accumulate exposure to this
asset, even if the currently torrid growth rate slows. By extrapolating current trends, we
can foresee that financial products will become more numerous, more standardized, and
more fitted to capital markets norms. At the same time, secondary markets will come
into existence, and ratings agencies and researchers (both commercial and academic)
will focus more attention on the sector. Specialized hedging tools will ease the
distortions of too much lending in foreign currency. These developments should abet
liquidity and help to give investors comfort that microfinance is suitable for regular
allocations of portfolio investment. In effect, investor demand for assets itself will
become an important and self-fulfilling driver of progress in microfinance.

Moreover, as MFI owners and managers grow accustomed to an environment in which a

deep pool of commercial funding is available for the well-run, expanding MFI, we can
expect strategic transactions – mergers, acquisitions, buy-outs, roll-outs, listings, etc. –
to become integral elements in the lifecycle of successful MFIs. This will result overall
in stronger, more efficient and more skilled institutions better serving clients’ needs.

Of course, too rapid growth could also lead to speculation, overheating, and a crash, as
we have seen many times before in financial markets, from junk bonds to high tech. And
certainly some MFIs will expand too quickly and lose control of their costs and their
loan books, or cut rates too aggressively for competitive reasons, or push too much
money into the hands of their clients too soon. Microfinance is no more immune to
excess than any other business activity. But the inherent robustness of the microfinance
business model lays down a strong foundation for solid growth, and the sizable potential
market ensures absorption capacity for substantial fresh financing.

Overall, the distinctive focus of microfinance on “banking the unbankable” – bringing

financial services to customers outside the formal financial system – gives it a unique and
attractive profile of risk and reward that can draw institutional investors seeking
diversification and absolute return -- even those who are unmoved by the prospect of
promoting social values.

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